Flash From The Past: Nothing Has Changed Since LTCM Bailout In 1998 (May 2010)

Ten years before this latest crisis, the U.S. government engineered the bailout of a financial firm that had borrowed billions of dollars to make big bets on exotic securities. The firm was a hedge fund called Long-Term Capital Management.

James G. Rickards, as the firm’s top lawyer, negotiated the terms of the $3.6 billion deal, organized by the Federal Reserve Bank of New York, that forced other Wall Street firms to bail out LTCM. And now, in an interview with a brokerage newsletter, he says the federal government has failed to apply any of the lessons learned from that epic 1998 bailout — a failure that led to the current crisis and could lead to more.

Rickards also says that megabanks should be broken up, all derivatives should be traded via a clearinghouse, Fannie Mae and Freddie Mac should be liquidated, and more financial regulation is needed.

“Western capital markets came to the brink of collapse in 1998, when hedge fund Long-Term Capital Management, with a trillion dollar web of counterparty risk at all the major banks and brokers of the time, failed,” Rickards said in an interview with Welling@Weeden, a publication of Weeden & Co., an institutional broker. “Then Fed Chairman Alan Greenspan and Robert Rubin, who at that juncture was Treasury Secretary, called it the worst financial crisis in 50 years.

“What strikes me now, looking back, is how nothing was changed; no lessons were applied. Even though the lessons were obvious, in 1998,” he said. “Risk models needed to be changed, or abandoned. Leverage had to be slashed. Derivatives had to be traded on exchanges or cleared through clearinghouses. Regulatory oversight needed to be ramped up.”

But instead, he notes, “the government did just the opposite. Glass-Steagall was repealed in 1999, so that banks could become hedge funds. The Commodities Futures Modernization Act of 2000 permitted the creation of more unregulated derivatives. The Basel II Accords [a global bank regulatory framework] and changes in SEC regulations 2004 permitted more leverage.

“The U.S., in effect, stared near-catastrophe in the eye, with LTCM, and decided to double-down.”

The financial blog Zero Hedge spotlighted the published interview on Thursday.

Rickards also expresses concern about the greater concentration of money in Wall Street. He says the toxic assets are still there, although the Fed and the Treasury have “helped paper things over by changing the accounting rules.”

And he outlines two possible scenarios: “Either the slide resumes and we finally get to the market bottom that we never hit in 2009, or they keep printing money to paper it over, eventually destroying the dollar and undermining the entire economy.”

To fix the system, Rickards advocates a host of proposals:

Forcing derivatives to be traded through clearinghouses, which are entities that essentially force counterparties to put money on the table before trading;

The “Volcker Rule,” named after former Federal Reserve Chairman Paul Volcker, which calls for banks to stop high-risk trading with their own money and puts a cap on how big current megabanks and financial institutions can grow;

“Bringing back something like Glass-Steagall,” a Depression-era law that separated Wall Street investment banking from Main Street commercial banking;

“Liquidat[ing] Fannie Mae and Freddie Mac once and for all and get[ting] back to a private housing market”;

Fixing the credit rating agencies by “eliminat[ing] the conflict of interest inherent in the issuers of securities paying fees for ratings”;

“Break[ing] up the big banks and let[ting] them choose whether they want to be commercial banks or investment banks, but not both.”

Unfortunately, Rickards notes, “I don’t see any of those solutions being seriously pursued.

“Sometimes lip service is paid to the need to do something, but no one is doing anything.”